Battipaglia: Fixed-Income Forecast
10/16/2002 12:00 am EST
The complexities of fixed-income markets makes this a difficult topic for the average investor. Joe Battipaglia, chief investment officer for Ryan, Beck & Co., has an uncanny knack for explaining these difficult markets in highly understandable terms. Here, he provides a long-term overview of expected future Fed policy, bond prices, interest rates trends, and equity prices.
“Is it likely that bond prices are nearing a major top? We think that they are, but one or more catalysts are necessary to bring about a reversal. These catalysts are: (1) clear signs of improvement in the US economy, (2) a change in bias by the Federal Reserve, and (3) a sustained rise in stock prices. As in previous investment cycles, it is impossible to pinpoint exactly when such a shift might occur, but is important to recognize that valuation risk matters. Should the US economy return to a sustainable, positive growth path in the coming quarters, it is unlikely that the market will allow bond yields to stay where they are. A real, inflation-adjusted yield of 1.46% on a ten-year Treasury is simply not that attractive relative to historical returns or the potential long-run returns on equities from here.
“Currently the Fed Funds rate (1.75%) is below the forecast rate of inflation (2.25% based on a recent Federal Reserve survey of economists). We do not expect the Fed to remain this accommodating for long. The last cycle involving falling real interest rates lasted for 3.5 years as the Fed worked through the 1990-1991 recession, the S&L crisis, and the Gulf War. By the second quarter of 1992, the Fed Funds rate reached a low of 3% with an underlying inflation expectation of near 3.25%. By the first quarter of 1995, the Fed Funds rate reached 6% with a 3.5% rate of inflation.
“In our opinion, it is not too early to begin thinking about higher short-term interest rates over the next 12-24 months as the economy recovers and the Federal Reserve looks to establish a positive real rate for short-term money. We expect the Fed Funds rate to reach 4%-4.5% by the early part of 2004 (this represents an inflation rate of 2.5% and a forecast for real short-term interest rates of 1.5% to 2%). We also anticipate some flattening in the yield curve from the current 200-basis-point spread between ten-year Treasury rates and overnight money rates. During more normal times in the past, the ten-year Treasury bond was priced to yield 75-100 basis points over Fed Funds. Therefore, we expect that the ten-year Treasury will be priced to yield 4.75%-5.75%."
As for stocks, Joe Battipaglia is upbeat. He says, “A more rational environment is a good thing. When expectations are reasonable, risks are reduced and longer-term opportunities become more plentiful. Will investors be rewarded for taking on risk? We believe so. The fact that expectations have been dramatically lowered and risk premiums are excessively high (currently 5.2% versus an average 3.7% rate since 1980), suggest that there is room for combined earnings growth and multiple expansion. We believe that the equity market remains significantly undervalued and we expect this valuation gap to disappear over time. We believe that the market's fair value is at least 1,150 for the S&P 500. This implies upside of 40% to fair value.”
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